Q. I'm about to move our investments so they fit an asset allocation similar to one of your Couch Potato portfolios. Ours will be made up of five classes: small U.S. stocks, large U.S. stocks, international stocks, total bond, and health care. My difficulty is that my wife and I have six different accounts between us: a 401(k), 403(b), two Roth IRAs, one traditional IRA, and one regular account.

Do you have any suggestions about how to break up the asset classes between the many accounts? Should we try to have each account hold one to three asset classes? Or is there a better way? As far as tax considerations are concerned, we only have one taxable account, so it will hold our Vanguard 500 fund.

---S.C., by email


A. Sadly, most people solve this problem by not having any accounts at all. So when you get frustrated, remind yourself that this is a great problem to have. Let's start by identifying which accounts should tend to get which kind of assets:

•  Taxable accounts should get your most tax efficient assets. Your selection of the Vanguard 500 Index fund is perfect for such accounts. It realizes little in capital gains due to low turnover, and what is taxed gets the low 15 percent rate. The only normally taxable money in this account should be your cash reserve--- and even that can be moved out to a flexible investment like I Savings Bonds.

•  Roth IRAs should be diversified portfolios with a bias toward long term growth because these accounts face neither taxes nor required minimum withdrawals. This also favors using the Roth IRAs to hold the most volatile assets, such as the small cap index funds. That means you should have significantly more equities here than fixed income.

•  401(k), 403(b), and traditional IRA accounts should prefer fixed income investments over equities because they are tax deferred but face required minimum withdrawals.

As a practical matter, you'll probably need to do most of the rebalancing and adjustments in the accounts that (1) have the most money in them and (2) that get the most new investment money. That's likely to be the 401(k) and 403(b) accounts. As a consequence, you'd do well to keep your core large cap investment in the taxable account, your core small cap investment in the Roth IRA, and your core fixed income investment in your IRA. Then use the new money going to 401(k) and 403(b) accounts to keep the entire portfolio balanced.


Q. I like indexing. I am aware of the original Couch Potato and its variations.   But what about mid-cap stock indexes for the Couch Potato? Mid-cap indexes are adding new companies that are growing. Of course, there are some that are large that have declined to become mid-caps. On balance, I would think that the new growth companies are more important. What do you think?

---T.D., by email from Dallas


A. Long ago, when I first started writing about Couch Potato investing, the stocks in the S&P 500 Index accounted for nearly 85 percent of all market capitalization in America. Today, that figure is down to about 75 percent. During that time I changed the original Couch Potato portfolio by substituting a total stock market index fund for the S&P 500 index.

Doing that was a de facto way to incorporate both mid and small cap stocks without making a commitment larger than their role in the economy. Making the commitment through a single index fund has another advantage. The turnover in the portfolio is smaller than the turnover in mid or small cap index funds. This reduces transaction costs and makes the portfolio more tax efficient. The turnover rate in the Vanguard Small Cap Index fund, for instance, is 19 percent. The turnover in its mid cap index fund is 16 percent. The turnover rate in its Total Stock Market Index fund, on the other hand, is only 4 percent, only slightly higher than the 3 percent turnover in its S&P 500 fund.

While there is some discussion about the quality of the early data, most of the academic research indicates that smaller cap companies provide a higher long term return than large cap companies. The Ibbotson Associates data, for instance, divides all the listings on the New York, American, and Nasdaq exchanges into deciles. Top decile (largest) companies returned less than 10 percent, annualized. But those in the smallest four deciles return about 12 percent.

Over time, that compounds to enormous differences.

What's the catch?

Simple: more risk. The smaller stocks were nearly twice as price volatile as the large stocks.